What matters to company owners, of course, is actual cash flows over the long-term future for their business (i.e. the “forever” horizon). When deciding whether to buy that business today, strict fundamental investors also consider the likely cash flows they may capture over the “forever” horizon. What determines the price they must pay to invest, however, is expectations for those long-term cash flows as of today, as determined by the marginal investor. Later, say in five years, if they want to sell that business or raise capital, then expectations for cash flows from year six to “forever” will influence the price they receive. While the forever horizon is nice, most investors who are seeking an eventual exit, as well as all companies that may require future capital to grow at some point before “forever,” care both about the actual cash flows and about how expectations for those long-term cash flows may affect valuation in the future.
Forever is a long time, and there are many key drivers that could change an awful lot during that time. There is enormous value in mapping out how future cash flows may unfold, particularly across multiple scenarios, if it can be done in a logical and efficient way. Even if we can reasonably estimate these cash flows for many years, however, discounted cash flow (“DCF”) has gotten a bad name in many circles because it requires “too many assumptions” and depends a lot on the discount rate one chooses for the DCF. It also takes a lot of work to produce and communicate, even for a single base case.
As a result, many managers and investors use multiples to determine the long-term value of a business. It is generally easy to observe any number of fundamental financial measures (like revenue) for the prior year, quite commonplace to predict these measures with confidence for the upcoming year, and often feasible to estimate them a few years out. Many managers and investors also have confidence in their ability to forecast the “right” multiple to apply to that measure based on a peer group of comparables (“comps”) and the company’s outlook for key things like scale/stability, growth outlook, and eventual peak profitability. With those two strokes, simple multiplication solves the valuation puzzle:
Fundamental Financial Measure x Multiple Applied = Valuation
Beyond simplicity, the single biggest reason most investors use multiples is that everyone else uses multiples: You are generally buying from one who uses multiples and later selling to another who also uses multiples. Investors who have used multiples in their valuation decision-making for some time have a comfortable confidence about what ranges “make sense” based on the characteristics of a business: They rely on their business knowledge and pattern recognition skills to ensure that the company they are valuing is compared to the “right set of comps,” and they adjust the multiple upwards for favorable characteristics - such as higher growth, better profit margins, longer period of dominance, larger scale/stability/competitive moat - and downwards for unfavorable factors relative to comps. Organizations also gravitate around multiples: The analyst knows what multiple the partner is comfortable paying, the CEO understands what multiple his board will accept for an acquisition, and everyone “knows” where the comps have traded. It is a lovely, well-ordered way to think about the world.
Let’s take a closer look at each step.
To which fundamental financial measure should the multiple be applied?
Revenue, earnings before interest, taxes & depreciation (“EBITDA”), free cash flow (“FCF”), or earnings per share (“P/E”)? It depends on the stage and nature of the business. “Everyone knows” that revenue multiples are best for high growth business without earnings, EBITDA fits well for a consolidating roll-up of cash flowing companies, and P/E is the tool of choice for most public stocks that are expected to produce profits for many years to come. Sometimes, of course, it is best to use custom measures like “EBITDA ex. growth” ignoring expenditures that the company may not need to retain existing customers, annual recurring revenue (“ARR”) based on the latest month or quarter, customer acquisition cost to customer lifetime value (“CAC to LTV”), adjusted earnings, P/E to growth (“PEG ratio”), or many others. Fundamental financial measures abound, and it is easy to produce near-term estimates for most of them.
For a given fundamental financial measure, which number should one use for the multiple itself?
It all comes down, of course, to multiples for the comps, the set of companies that one chooses as similar. What makes each company a “good comparable” to include in a valuation framework? Is it similarity in industry? Business model? Region? Product mix? Company stage? Growth prospects? Profit margins now or at scale? Target market? Competitive position? Product features? Long-term contracts? Low churn rate? Patent protection? Management ability to execute? Access to capital? Scale? Number of competitors? Number of failed competitors? Strategic partners? Regulatory landscape? The comps are the “right” ones only if the characteristics of their outlook are similar to the company that we are valuing. The real question is: How comparable are the comps, and what adjustments should we make to arrive at the multiple for our company?
Last, will the multiple be the same years in the future when the company needs to raise capital, or when we want to sell our investment to someone else? Who will be the marginal investor who decides the multiple applied at that future horizon, and what will they base their thinking around at that time? How might the two obvious drivers - comps group and multiples for that comps group - have changed by the next valuation horizon?
How well can we anticipate what multiples will be at an exit years into the future?
Can we do a better job today of predicting the future multiple by modeling rigorously the actual future cash flows scenarios over the forever horizon so we have a valid snapshot of the company outlook as of any horizon? Can we predict better how expectations for those future cash flows may change with actual financial results to date, and with certain milestones reached? How can we predict the marginal buyer’s future appetite for comps based on the outlook for the relevant characteristics and the overall sentiment around fear and greed?
Managers and investors generally understand that fear can play a role in lower multiples and greed in higher multiples, and they certainly know that the performance of the business will influence both the chosen fundamental financial measure and the outlook out to the forever horizon, which drives the multiple.
Nonetheless, they feel better avoiding the “false precision” of predicting future cash flows and the “complexity” of considering probability. With confidence, they predict a near-term financial measure and apply a multiple to compute the entry price paid, and then they live with whatever exit multiple they ultimately receive. They may run an upside and downside case, or they may briefly consider a sensitivity table of various multiples and various fundamental financial measures, and they discuss various stories that could lead to great, good, or poor outcomes, but curiously they do not focus on the odds of various changes in future cash flows, much less on the odds of various changes in expectations for future cash flows, despite recognition that those expectations influence multiples and valuation.
It sounds hard to estimate the probabilities of changes to actual long-term cash flows. Forever is a long time, and there are many key drivers that could change a great deal. It sounds even harder to estimate the probabilities of changes to expectations for future cash flows alongside scenarios for milestones reached and for market conditions. So hard, in fact, that it simply is not practical to go beyond a few multiples or DCF scenarios, or to estimate probabilities even for those few, using spreadsheets, memos, and PowerPoint slides.
However, it is practical with the Bullet Point Network Platform. We prefer to supplement these traditional valuation methods with a logical set of scenarios that probability-weight how cash flows may actually unfold, what milestones may affect expectations for long-term cash flow at different future horizons, and which events may be conditional on which other events. We do not just do this one time during the initial underwriting for an investment. We keep that underwriting living and breathing as new evidence becomes available and expectations change.
We believe in Connecting Stories to Statistics to better anticipate changes to exit multiples and to make better investment and strategy decisions. Take a look at the 3 specific steps that follow to see just how you can do so with us. Let’s Connect Stories to Statistics…